An Information-Based Explanation for Inelastic Demand

In many frictionless asset-pricing models, investor demand curves are virtually flat. Koijen and Yogo (2019), in contrast, estimate surprisingly inelastic demand. In this paper, we investigate the role of information in addressing this puzzle. In a noisy rational expectation equilibrium model, we show that uninformed investors are rationally reluctant to trade against price movements driven by informed investors, implying uninformed inelastic demand. To test this prediction, we use a firm-level vector autoregressive model (VAR) and verify that price changes predict only small fluctuations in the next year's expected returns for uninformed investors. We find that an investor who only observed public information would rationally have a demand elasticity of 0.15. Using three portfolio-based proxies of informedness, we further empirically verify that more informed institutions have higher demand elasticities